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Transfers Incident to a Divorce

Divorce can be a very complex matter, both
emotionally and financially. The financial complexity is illustrated
by the many tax implications of divorce. People going through divorces
often find themselves in disputes with the IRS. The Tax Court recently
decided one such matter.

John and Louise Young were married in 1969 and divorced in 1988.
(Note: The court combined two cases into one because they concerned
the same transaction. This discussion follows the case from Louise’s
perspective.) In October 1989 they entered into a property settlement
whereby Louise received a promissory note for $1,500,000, previously
held by John. The note was secured by property John received as part
of the settlement. He was to pay the note to Louise in five annual
installments, which included interest. The settlement also provided
that John would pay legal and collection fees if he defaulted.

John defaulted on the note in 1990, and Louise filed suit to collect
the amount he owed her. A judgment was entered in her favor. In 1991,
John paid Louise only $160,000. Louise properly recognized this amount
as interest income on her 1991 income tax return.

In 1992, Louise again filed suit to execute the rest of the 1991
judgment. In December 1992, John and Louise entered into another
settlement whereby he transferred the land that secured the note to
Louise in exchange for surrender and cancellation of the note. John’s
basis in the land was $130,794. This settlement discharged all of his
debts to Louise, which totaled $2,153,844 including the $1,500,000
principal amount, accrued interest of $344,938, legal expenses of
$300,606 and collection expenses of $8,300. The settlement also gave
John the option to repurchase the land for $2,265,000. John assigned
this option to a third party, who exercised it and acquired the land
from Louise in 1993. Louise’s attorneys collected $300,000 directly
from the sale proceeds in settlement of Louise’s legal fees. Louise
received the remainder.

The case does not give details about how Louise wanted to treat the
transaction. Presumably, she wanted receipt of the land to be
considered a settlement of the $1,500,000 promissory note from John.
If that had been the case, she would have a capital gain equal to the
excess of the value of the land she received over the face value of
the promissory note. This treatment would have given Louise a
$2,265,000 fair-market-value basis in the land when she sold it to the
third party in 1993 instead of John’s $130,794 carryover basis. Such
treatment would obviously have created for her an advantageous tax
result.

The IRS claimed the transfer of the land to Louise fell under
section 1041, which says that, in transfers of property from an
individual to a former spouse, the transferor recognizes no gain or
loss and the transferee’s basis is the same as the transferor’s
adjusted basis if the transfer is “incident to the divorce”—that is,
the transfer occurs within one year of the divorce or is “related to
the cessation of the marriage.” Further, temporary regulations provide
that certain transactions occurring within six years of a divorce may
still be considered incident to divorce (temporary regulations section
1.1041-1T(b), Q&A-7).

Result. For the IRS. All parties agreed the
1989 settlement was incident to the divorce because its purpose was to
divide marital property. Since the 1992 settlement was the result of
legal action regarding the 1989 settlement, the Tax Court found this
settlement was also incident to the divorce. Even if the regulations
did not apply here, the transfer was related to the cessation of the
marriage. Therefore, section 1041 applied.

The IRS also claimed that the money Louise received to pay her legal
fees should be included in her gross income. Louise contended that,
since John was obligated to pay the legal expenses under the 1989
settlement, the amount he paid should not be included in her income.
The Tax Court found that the obligation to pay the legal fees was
Louise’s and, thus, she should include the amount paid on her behalf
in her gross income. The Tax Court cited Glenshaw Glass Co.
(348 US no. 426 (1955)) and O’Malley (91 TC no. 352, 358
(1988)), in support of its position that taxpayers are treated as
receiving taxable income when a third party pays an obligation on
their behalf.

CPAs and their clients should be aware of section 1041 implications
when transfers of property result from a divorce, including those that
occur some time after, but are incident to, the divorce. Ignoring the
provisions of this section could be disastrous for both the client and
the practitioner.

John B. Young, et ux. et al. v.
Commissioner, 113 TC no. 152 (1999).

—Prepared by Eddie Metrejean, CPA, instructor, University of
Mississippi, E. H. Patterson School of Accountancy, University,
Mississippi. His e-mail address is emetreje@olemiss.edu .